Inventory investment and aggregate fluctuations with idiosyncratic shocks

An important insight of our analysis is that changes in the persistence and variability of idiosyncratic order costs and productivities alter the distribution of firms over inventory levels. This, in turn, affects the extent and speed of firms' responses to aggregate shocks, and thus the model's ability to reproduce high-frequency aspects of the aggregate data. When firms have greater certainty about their order costs, and when shifts in their relative productivities are transitory, they adjust their average inventory holdings faster following an aggregate shock. In such cases, the model succeeds not only with respect to the business cycle facts mentioned above, but also in reproducing two essential high-frequency observations, the negative correlation between sales and inventory investment and the greater volatility in sales relative to production.